Archive for the 'Elasticity' Category

Feb 25 2015

Art, meet Economics

Here’s a great story about the importance of getting an education in both Art and Economics: ArtNet News – New York Times Exposes Peter Lik Photography SchemeGive it a read before reading the rest of this post.

Lik

There’s a lot of interesting Microeconomic applications of this story. Lik makes 995 prints of a photograph, sells them for cheap at first, but as they become more “scarce” the price rises. If the prints were, in fact, becoming “scarcer” then there might be a justification for their prices rising, and it is this illusion of increasing scarcity that tricks his (apparently un-art-educated and un-economics-educated) buyers into being willing to pay a much higher price for the final few prints than was paid for the first several prints sold.

In fact, the prints don’t become scarcer as more are sold, rather, the quantity supplied remains constant at 995. In most markets, to sell additional units of a product, the price typically has to decrease (since those who are willing to pay the most will buy first), but in the market for Lik’s photographs, those willing to pay most are the LAST buyers of the good. He has managed to reverse the rationale behind consumer behavior by creating an artificial sense of increasing scarcity, and thereby tricking his buyers into believing they are investing in an asset that increases in value over time rather purchasing a good that only loses value once it leaves the gallery.

Assuming demand for a particular print is fixed in a period of time, there really should be a single price as long as the quantity supplied does not change (which it doesn’t!!). But by making his buyers think the scarcity is increasing (by implying that the more are sold, the fewer the there are available to buy), demand actually rises as more prints are sold and the the price correspondingly increases. There is no actual change in the quantity supplied, only demand, and the reason demand is increasing is the belief that the rising price signals increasing scarcity, thus the ability to sell the art for an even higher price in the future. Art can be an investment, like gold, which people demand more of when the price is rising, because of the anticipation of future price increases (and thus the ability to make a profit on the purchase and future sale of the asset). As it turns out, the secondary market for Lik’s prints is tiny and few buyers have ever turned a profit on their purchase of a Lik print.

The fact that the prints’ prices are rising is evidence only of Lik’s monopolistic, price-making power, not a real increase in the market value of a Peter Lik print. Lik himself reveals this ruse when he says about his art, “”It’s like a Mercedes-Benz, you drive it off the lot, it loses half its value.”

The moral of this story: If you don’t study both ART and ECONOMICS in school, never pretend to be a skilled art collector, because you’re only being tricked by scam artists (and savvy businessmen!) like Peter Lik!

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Feb 07 2013

Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition

Related Unit: IB Economics Unit 4.7 – Balance of Payments (Unit 3.3 in the new IB Economics syllabus)

Topic: The Marshall Lerner Condition and the J-Curve

Learning Goals/Objectives:

  • For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
  • For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
  • For students to evaluate the argument that a country will always benefit from a weaker currency.

Test of prior knowledge:

  1. Define ‘price elasticity of demand’ and explain how it is measured.
  2. With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
  3. Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
  4. How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?

Part 1:

The exchange rate of Japanese Yen in the United States over the last two years:

Take a snapshot of your two-year exchange rate diagram in OneNote, then copy and paste the questions below into the page.

Questions to answer in OneNote:

  1. Write a brief description of the changes in your country’s exchange rate over the last two years. (2 marks)
  2. Focus on two specific time periods from during the last two years: One in which your currency appreciated noticeably and one in which it depreciated noticeably. These could be periods of just a couple of days or longer periods of weeks or more. Highlight these in two different covers in your graph.
  3. Describe what is happening to your currency during the two time periods you highlighted in your chart. (2 marks)
  4. Explain TWO factors that may have caused the currency to change in value. (2 marks)
  5. Given the changes to the exchange rate you identified above, what would you predict would happen to your country’s current account balance over the two periods identified? Explain. Following appreciation – in the short-run and in the long-runFollowing depreciation – in the short-run and in the long-run. (4 marks)
  6. Why does the price elasticity of demand for imports and exports increase over time following a change in a country’s exchange rate? (2 marks)
  7. Draw a J-Curve showing the likely change in your nation’s current account balance following the period of depreciation of its currency shown in your chart above and explain its shape, referring to your country’s currency. (2 marks)
  8. For both the period of appreciation and the period of depreciation you identified above, explain the impact of the change in exchange rates on the following (4 marks)
    • a firm that imports its raw materials from the other country
    • a firm that exports its finished products to the other country
    • consumers who buy imports from the other country
    • a firm that produces good for the domestic market and competes with firms from the other country

Part 2:

Read the following article:  How Far Will the Dollar Fall?’ by Richard W. Rahn. Based on the extracts below, answer the questions that follow.

Some applaud the dollar’s fall because they believe it makes U.S. exports less expensive and that higher demand will cut the trade deficit. The downside of a low-value dollar is that it makes all the imports we consume more expensive, including raw material and parts used by U.S. businesses, and makes it costlier for U.S. dollar holders to travel or invest outside the U.S. A continued drop in the dollar’s value could destabilize the international economy, leading to a worldwide recession.

  • Why might the weaker dollar worsen the US trade deficit? Under what conditions would the weaker dollar improve America’s trade deficit? (2 marks)

Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar’s value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit.

  • How does a large financial (capital) account surplus allow the United States to maintain a large current account deficit? (2 marks)

The world now is actually on a two-currency standard — the dollar and the euro. China in effect has fixed its currency to the dollar for the last two decades, and the Japanese central bank only allows the yen to fluctuate within a limited range against the dollar.

  • How do exchange rate controls by China and Japan reduce the likelihood that a weaker dollar will improve the United States’ current account balance? (2 marks)

So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks’ and private investors’ demand for dollars grow, and the current account deficit can be sustained.

  • If investments in the United States began earning lower returns relative to investments in other countries’ financial and capital markets, what would ultimately happen to the US balance of payments in its current and financial accounts? Explain (2 marks)

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

4 responses so far

Nov 09 2012

Economic arguments for and against a carbon tax

Reuters – Long-shot carbon tax suddenly part of fiscal cliff debate

The article above suggests that during Barack Obama’s second term as president of the United States, the country may begin to seriously consider imposing a tax on carbon dioxide emissions. The justification for such a tax, points out the article, is two-fold:

The aftermath of Superstorm Sandy, which devastated parts of the U.S. East Coast last week, has raised fresh questions about the links between climate change and extreme weather events, which also makes the idea of a carbon tax more appealing.

A carbon tax is a mechanism to charge emitters of greenhouse gases, such as power plants and oil refiners, for each ton of carbon dioxide they emit.

Prospects for such a tax as a way to address pollution and climate are probably dim in a still deeply-divided Congress, but some analysts say the measure would be more attractive if positioned as a source of new revenue.

In fact, a recent report by the Congressional Research Service, suggesting a $20 per ton tax on carbon emissions could halve the U.S. budget deficit over time.

Such a tax would generate about $88 billion in 2012, rising to $144 billion by 2020, the report said, slashing U.S. debt by between 12 and 50 percent within a decade, depending on how high the deficit climbs, the report said.

America’s government budget has been in deficit every year since 2000, meaning the government spends more than it collects in taxes. Fears over the growing national debt and the impact it will have on future economic growth potential have led many in the US government to look for new ways to earn tax revenue for the government, even some ways that have bene considered taboo until now.

In my year 1 IB Economics course this week we have been learning about and evaluating taxes and subsidies in the markets for various goods. Generally, we learn that government intervention in free markets worsens the overall allocation of resources in the market economy, imposes more costs on society than benefits, and therefore leads to a loss of total welfare. For example, a tax on American beef in Switzerland helps keep the price of imported meat high, benefiting Swiss farmers, but overall the higher price of meet and the reduced quantity and variety available to consumers harms many in society to the benefit of the few cattle farmers. Such a tax, it can be argued, creates a loss of total welfare in society, as the tax’s cost outweighs its benefit.

But not ALL indirect taxes (those placed on the production and consumption of particular goods) reduce total welfare in society. A tax on a good that is over-consumed by the free market may actually improve total welfare as the higher cost to producers leads to a reduced supply, higher price, and a reduction in the quantity demanded in the market. A cigarette tax is the classic example. Without taxes on cigarettes, more people would smoke, creating more harmful effects for society, such as the ills of second-hand smoke, higher rates of lung cancer, greater demand for health care and the higher prices that this increased demand create for all of society, even non-smokers. Cigarette taxes are so widely employed by government and accepted by society that there is no debate whatsoever about their use.

But taxes on other goods that create ills for society are highly controversial, and for good reason. Perhaps one of the most debated and divisive tax proposals of recent years has been on the emission of carbon dioxide, a greenhouse gas emitted during the burning of fossil fuels. The main emitters of CO2 in the United States are the country’s electricity generating firms, which burn coal, gas and oil more than any other industry in the country. CO2 emissions are measured in tons, and a CO2 tax would apply to each ton of the gas emitted by fossil fuel consuming firms.

Arguments against a carbon tax

The primary argument against a tax on CO2 emissions is that it would drive up the costs of energy production, leading to higher energy costs for the nation’s households and firms. This boost in prices would increase costs to producers of all other goods and services in the economy, effectively reducing the supply in several key sectors of the US economy, leading to falling national output, more inflation and greater unemployment. American industry would become less competitive with other nation’s producers, leading to more factories closing down and moving overseas, taking American jobs with them.

Such a conclusion requires that a CO2 tax would, in fact, lead to significant decreases in the amount of energy demanded by the nation’s households and firms. In other words, it assumes a relatively elastic demand for electricity. It also assumes that as the price of fossil fuel generated electricity rises, there will be few alternative forms of electricity for firms to switch to. This leads us to the arguments for a carbon tax.

Arguments for a carbon tax

Energy is an essential good that consumers (whether they be households or firms) demand in large quantities regardless of the price. A carbon tax, which increases the cost and decreases the supply of fossil fuel energy, will not significantly reduce the amount of fossil fuel energy consumed in the United States; at least not in the short run, during which there will be very few substitutes for fossil fuel energy available to consumers.

However, one outcome that proponents of the tax hope for is an increase in the demand for alternative energies, such as wind and solar, which do not require the burning of fossil fuels. Such alternatives are not currently price-competitive with fossil fuels, but a carbon tax would make them more competitive, increasing demand for alternative energies and leading to a greater percentage of America’s total energy production coming from wind and solar.

The graphs below show the desired outcome of a CO2 tax on the markets for fossil fuel energy and renewable energies.

Notice that the tax does not lead to a significant decrease in the quantity of fossil fuel energy consumed in the short run. Businesses in the US will face higher costs, but energy costs are a relatively small proportion of most US industries’ total costs. (The biggest cost faced by US firms, not surprisingly, is labor costs). But the highly inelastic demand assures that fossil fuel energy prices will rise, leading to greater interest from consumers in alternative energies. In the graph on the right, we see an increase in the demand for renewables, leading to a greater quantity being produced.

But what might the long-run impact of a carbon tax be on the US energy sector? As we can see in the graph on the right above, greater demand for renewables will drive their prices up, which over time will increase the appeal of renewable energies to the country’s electricity producing giants. Slowly, the number of renewable energy producers will grow, as old coal or gas burning electricity plants are decommissioned and new wind or solar plants are installed. The supply of renewable energies should rise while the supply of fossil fuel energy should decrease. The result is an ever growing percentage of America’s total energy production generated using wind, solar, or other renewable sources of power. The graphs below show the possible long run impact of a carbon tax in the fossil fuel and renewable energy sectors.

Here we can see that in the long-run, the prices of renewable energies and fossil fuel energies will become closer as the supply of energy produced using wind and solar grows, making it more price-competitive and therefore reducing the demand for fossil fuel energies.Presumably, if the outcomes described above come to pass, the proposed carbon tax could lead to meaningful reductions in America’s greenhouse gas emissions over the long run, as the composition of the nation’s energy production slowly transitions away from non-renewable fossil fuels to renewable, non-polluting energy sources.

But what about the other reason the government is considering a carbon tax now? Remember those fears over the national debt and deficit? How effective would a carbon tax be at raising revenue to help the government balance its budget? To determine this, we must look again at the first graph we drew, only examine the impact of the tax on government, not just the market for fossil fuel energy.

In the graph above, we see that the tax creates a large chunk of tax revenue for the government, “about $88 billion in 2012, rising to $144 billion by 2020″. These figures seem optimistic, especially if the previous outcome in which the demand for fossil fuel energies falls in the long run comes to pass. But for now, at least from this Economics teacher’s perspective, a tax on carbon is a good first step towards both reducing American’s dependence on fossil fuels and generating desperately needed government revenues.

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Nov 01 2012

Has the Baby Market Failed?

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

  1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
  2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
  3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
  4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
  5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

15 responses so far

Sep 28 2012

Bad crop equals higher incomes for farmers – what’s up with that?

Despite Record Drought, Farmers Expect Banner Year

Listen to the story above. According to the report, farmers in the American Midwest have seen their incomes reach new highs this year, despite the terrible harvest resulting from a nationwide drought.

This is curious. The drought starved crops of water, forcing farmers to harvest in the middle of the growing season, essentially destroying much of their harvest for the year. So the question is, how does a BAD harvest result in GOOD incomes for farmers?

Believe it or not, the answer to this riddle requires an understanding of elasticity; specifically, price elasticity of demand (PED). PED measures the responsiveness of consumers to a change in the price of a good. The PED for a good can be measured between two prices by using a simple formula:

  • PED = the percentage change in the quantity of a good demanded divided by the percentage change in the good’s price.

The result of this calculation, which is known as the PED coefficient, will always be a negative number. Why will the PED coefficient be negative? Think back to the law of demand, which states that there is always an INVERSE relationship between price and quantity demanded of a good. Since PED measures how much the quantity demanded changes in response to a particular change in price, the coefficient of PED must be negative, since price and quantity always change in the opposite direction.

So back to our farmers who are enjoying high incomes despite the terrible harvest. What does this have to do with PED? Well, that’s what I want you to figure out. In the comments below, explain how an understanding of price elasticity of demand can help us understand why farmers whose crops were largely destroyed by drought ended up earning higher incomes than they expected.

 

8 responses so far

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